One Greenspanian innovation that surely can (and, we believe, will) survive Greenspan’s reign is his choice of monetary policy instrument. Greenspan focused—or perhaps we should say refocused—the Fed on setting the federal funds rate. More important, however, he has made it clear since 1993 that he thinks of the Fed as trying to set the real federal funds rate and, more particularly, the deviation of that rate from its “neutral” level...
The concept of the neutral (real) rate of interest dates back to Wicksell (1898), who called it the “natural” interest rate, meaning the real rate dictated by technology and time preference. In modern New Keynesian models of monetary policy, it often appears as the real rate of interest that makes the output gap equal to zero, which makes the difference between r and r* a natural indicator of the stance of monetary policy. As with the natural rate of unemployment, there are also many ways to estimate the neutral rate of interest. Some propose measuring the neutral interest rate as the rate at which inflation is neither rising nor falling (Blinder, 1998); others use low-frequency movements in output and real interest rates (Laubach and Williams, 2005); and still others prefer to “back it out” of an economic model as the real rate that would obtain under price flexibility (Neiss and Nelson, 2003).
[1] This concept first appeared in his July 1993 Humphrey-Hawkins testimony (Greenspan, 1993), and was controversial at the time. There, Greenspan referred to judging the stance of monetary policy “by the level of real short-term interest rates” and noted that “the central issue is their relationship to an equilibrium interest rate,” which he defined as the rate that “would keep the economy at its production potential over time.”